Pricing Capital Under Mandatory Unbundling and Facilities Sharing

The regulation of telecommunications, railroads, and other network industries has been based on mandatory unbundling and facilities sharing entrants have the option to lease part or all of incumbents' facilities if and when they desire, at rates determined by regulators. This flexibility is of great value to entrants, but because investments are largely irreversible, it is costly to supply by incumbents. However, pricing formulas used by regulators to set lease rates for capital do not compensate incumbents for this flexibility, so that incumbents are effectively forced to subsidize entrants, discouraging further investments. This paper shows how pricing formulas used to set lease rates can be adjusted to account for the transfer of option value from incumbents to entrants, and estimates the average size of the adjustment for land-based local voice telecommunications in the U.S.